Is Pennsylvania Jeopardizing Drilling to Fix the Budget Shortfall?

Pennsylvania is once again trying to pass a severance tax, to help balance a budget shortfall, leaving the natural gas industry worried about their future.

JKLM Energy is extremely disappointed with current developments in which the Senate passed an amended Tax Reform Bill to include a severance tax on unconventional natural gas industry. As the talking points lay below lay out, this will only further restrict capital investment within the Commonwealth. It is also very disappointing to see the Senate renege on Impact Fee language that voided the bill if there was ever a severance tax.

If this amended bill passes in the House, the unconventional shale industry is left to wonder how often the state government will increase the severance tax in the future to help balance future budgets.

The Impact Fee has historically equated to an effective severance tax of 2.5% to 3.0%.

The analysis below assumes the Dominion South Point price for all production in the state. Most producers in the northeast part of state receive closer to the Leidy pricing index. This index only dates back to 2014, but results in an effective severance rate of 2.88%. The impact of state corporate taxes was excluded from this analysis, which would significantly increase the effective rate, particularly in comparison to other states.

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Other states that have higher severance tax rates offer specific and significant reductions for unconventional shale wells. In stark contrast, the majority of severance tax proposals in Pennsylvania target unconventional shale wells with the highest rates.

Pennsylvania natural gas producers compete directly with West Virginia, Ohio, Arkansas, Louisiana, and Texas to supply the majority of natural gas to the eastern United States and Gulf Coast. Some of these states have severance taxes that are significantly less than the proposed Pennsylvania taxes. While supporters of a severance tax point to higher severance tax rates in some of these states, they typically offer significant rate discounts for unconventional shale wells.

These differentials are based on real market transactions that take into account future pipeline projects and increased regional demand for natural gas. Even with the current proposed projects, the Appalachian Basin will continue to face a long-term, significant price disadvantage relative to its competition. The Leidy spot price over the next five years is an average of $0.69, or 24% lower than Henry Hub (NYMEX). One major concern over the Senate’s proposed severance tax is the fact the escalator is based on NYMEX. While the differentials have improved in recent years, the average NYMEX price in 2015 was $2.66 while the average Leidy price was $1.15. This would equate to an effective severance tax rate of 1.74% under their proposed language. Their severance tax scheme has its highest effective tax rates at the lowest prices.

One way for the Governor’s office to offset the cost of a severance tax would be to adopt aggressive pro-natural gas energy policy that would shrink this differential. Possible policies include the following:

Offering incentives for increased use of natural gas in manufacturing and transportation.

Reducing some of the burdensome regulations against the industry that provide little to no environmental benefit would also help to make Pennsylvania natural gas more competitive.

The Impact Fee is essentially a tax and consideration should be given to changing its name.

Supporters of additional taxes on the unconventional oil and gas industry will claim this is a matter of semantics, which it is. However, the Impact Fee is essentially a severance tax that was improperly named. Changing the name of the Impact Fee to Severance Tax will allow future policy discussions to focus on the first three points above, which have significantly more substance than current discussions around whether Pennsylvania should have a severance tax.

In light of the Senate’s most recent proposal, the Governor will still likely claim the industry is “not paying their fair share” because the official severance tax works out to roughly 1%, which would be the lowest in the country. He can make the claim that it is better than no severance tax and this was the best he could do with a Republican controlled Senate and House. This number increases to 3 – 4% if the name of the Impact Fee is changed, making his argument much less effective.

Claims that a severance tax will not affect investment and drilling in the state are unfounded and recent actions by major players suggest they are already looking to invest in other states.

Despite the fact that Pennsylvania sits atop two of the most prolific gas fields in the world, major players in the state have either left the state or spent significant money to acquire assets in other states, rather than deploying the capital to further develop or expand their Pennsylvania assets. The new acquisitions will also compete directly with their Pennsylvania assets for capital in the future. Examples include:

Southwestern’s acquisition of Chesapeake’s predominantly West Virginia assets in late 2014 for $5.4 billion.

Anadarko’s sale of its Pennsylvania assets for $1.24 billion in December 2016. This is likely a fraction of what Anadarko invested in the asset, and shows the capital market’s general trend away from investment in Pennsylvania.

In Conclusion

In conclusion, the natural gas industry and business community are left to wonder how pro-business Pennsylvania really is. The industry worked extensively with the legislature on an Impact Fee, which stated that a future severance tax would void the Impact Fee. It is very disappointing to hear that the legislature would consider reneging on this agreement simply for a very small, temporary fix to a budget shortfall, particularly when the legislature is comprised of its largest Republican majorities in decades. The natural gas industry and investors are left to wonder if they will be considered the state’s slush fund for future budget shortfalls, which will significantly stymie capital investment within the Commonwealth.